Fixed Assets and Depreciation Accounting

LECTURE 6

Correct perspective of long term assets or fixed assets

They have a useful life of more than a year They are used in the operations of business They are not intended for resale to customers.

LECTURE 6

Fixed Assets Accounting

Accounting for fixed assets involves dealing with following questions: 1. Determination of cost of acquisition of fixed assets 2. Allocation of cost of fixed assets over its estimated life 3. Accounting of disposal of fixed assets.

LECTURE 6

Cost of acquisition
Cost of a fixed assets comprises its purchase price, import duties and taxes on purchase and any other directly attributable costs of bringing the asset to working conditions for its intended use.

LECTURE 6

Following expenditures relate to the import of a chemical plant: 1. Customs duty on the plant 2. Clearing charge paid to the port trust. 3. Demurrage for delay in clearing the consignment 4. Freight 5. Transit Insurance 6. Repairs of some part damaged while the plant was unloaded at the port.
LECTURE 6
5

Some related aspects

Capitalization of Borrowing Costs: Interest paid in connection with the loan paid to acquire any fixed assets is added to the cost of that particular fixed asset till the point of commencement of production. . Such expenditure will be treated as revenue expenditure after commencement of production.
LECTURE 6
6

Basket Purchases
Some times a group of fixed assets may be purchased at a single lump sum price. In that case the total purchase price would be allocated among the various assets on the basis of their relative fair value. This fair value is usually determined by professional valuers.

LECTURE 6

For example if a firm pays Rs 2,50,000 for a building as well as land on which it is situated, how much should be taken as value of building and how much should be taken as value of land when the expert valuer fixes the market value of building at Rs 280000 and that of land as 120000.

LECTURE 6

Depreciation
Definition Difference between Depreciation, Depletion ,Amortization Basic Features of Depreciation Causes of Depreciation Objectives of providing Depreciation Factors affecting the amount of depreciation Methods of Recording Depreciation
LECTURE 6

Depreciation
Depreciation is the gradual and permanent decrease in the value of asset from any cause: By Carter Depreciation may be defined as the permanent and continuous diminution in the quality, quantity and value of an asset: By William Pickles

LECTURE 6

10

Features of Depreciation
The term depreciation is used only in respect of fixed assets Depreciation is a charge against profits Depreciation is different from maintenance Decrease in value of assets is permanent and perpetual.

LECTURE 6

11

Causes of Depreciation
Wear and tear Exhaustion Obsolescence Efflux of time Accidents

LECTURE 6

12

Depletion: This term is used in relation to natural resources such as mines, oil wells etc Amortization: This term is usually used in respect of intangible assets like patent , copyrights, goodwill etc.

LECTURE 6

13

Depreciation Accounting
Depreciation accounting is a system of accounting which aims to distribute cost or other basic value of a tangible fixed assets less salvage value (if any) over the estimated useful life of that particular asset in a systematic and rational manner. It is process of allocation and not valuation.

LECTURE 6

14

Objectives of Providing Depreciation

Ascertainment of true profits Presentation of true financial position Replacement of assets

LECTURE 6

15

Factors affecting the amount of Depreciation

Cost of the assets Estimated scrap Value Estimated useful life

LECTURE 6

16

Cost of the asset: This is the cost incurred in making asset available for use at the first instance. This amount is specific and known at the time of acquisition of the asset. Salvage value: This is the expected sales value of the asset at the end of its useful life.
LECTURE 6
17

Useful life: It is the period for which the asset can be used for production. Depreciable Cost: This is the original cost of the asset less its salvage value. Book Value: It is the original cost of the asset less depreciation to date. This is also known as WDV .

LECTURE 6

18

Method of recording Depreciation

Depreciation can be recorded in the books of accounts by two different methods: 1. when a provision of depreciation account is maintained 2. When a provision of depreciation account is not maintained.

LECTURE 6

19

Methods for providing depreciation

Straight Line Method or fixed installment method Reducing Balance Method Some other methods Depletion method Sum of years digits method(SYD) method Machine Hour rate method Group Depreciation method Depreciation or Sinking Fund method
LECTURE 6
20

Fixed Installment method or Straight line method

According to this method the amount of depreciation is calculated as follows: Depreciation= cost of asset- scrap value Life of asset Depreciation to be charged can also be expressed as percentage of cost. R = D*100 C

LECTURE 6

21

For example, an asset has been purchased for Rs 10,000 and it will have a scrap value of Rs 1000 at the end of its useful life of 10 years the amount of depreciation to be charged every year : Depreciation = 10000-1000 10 years = Rs 900 each year or 9%
LECTURE 6
22

Merits: This method is simple to understand and easy to apply. Demerits: 1. This method does not takes into account the effective utilization of assets 2. Total charge for the use of assets goes on increasing from year to year thought he asset might have been used uniformly from year to year. 23 LECTURE 6 .

Diminishing Balance Method

This method is also called as Reducing balance method.According to this method depreciation is charged on the book value of assets each year.

LECTURE 6

24

For example if the cost of an asset is Rs 20000 and the rate of depreciation is10%, the amount of depreciation to be charged in the first year will be Rs 2000. In the second year depreciation will be charged at 10% on the book value of asset( Rs 18000) and so on.

LECTURE 6

25

Advantages:
Total charge for the use of assets remain constant each year. This method is also simple to understand and easy to use.

Demerits: It is difficult to calculate the

rate of depreciation
LECTURE 6
26

Depletion Method
This is also known as productive output method. According to this method the charge of depreciation will be based on the following factors: 1. Total amount paid 2. Total estimated quantities of output available 3. Actual quantity taken out during the accounting year.

LECTURE 6

27

For example if a mine is purchased for Rs 20,000 and it is estimated that the total quantity of mineral in the mine is 40,000 tonnes, the rate of depreciation per tonn would amount to 50 paise per tonn. In case the output in a year amounts to 10,000 tonnes, the amount of depreciation to be charged to Profit and loss account would be Rs 5000.
LECTURE 6
28

Suitability: this method is suitable where the life of the asset can be estimated in terms of output. Eg. Ore deposit, oil deposit Advantages: Here the amount of depreciation is correlated to the productive use of asset Disadvantages: It requires making of a reasonably correct estimate of the amount of likely output otherwise amount charged by way of depreciation will not be correct.
LECTURE 6
29

Sum of years digits method

This method is on the pattern of Diminishing Balance Method. The depreciation is calculated according to the following formula:
Remaining life of asset(including current year)* cost Sum of all the digits of the life of the asset in years

LECTURE 6

30

For examples, if the cost of an asset is Rs 10,000 and it has an effective life of 5 years, the amount of depreciation to be written off each year will be:

1st year

2nd year

= __ 5_____ *10,000 1+2+3+4+5 = 5 *10000 =Rs 3,333 15 = _4__ * 10,000 = Rs 2,666 15

LECTURE 6
31

Machine hour rate method

Also known as Service hours method. This method takes into account the running time of asset for the purpose of calculating depreciation. Amount of depreciation is calculated as follows: Original cost of asset- scrap Value Life of asset in hours

LECTURE 6

32

For example, if a machine having a scrap value of Rs 1000 is purchased for Rs 20,000 and has an effective life of 10 years of 1,000 hours each, the amount of depreciation per hour will be computed as follows: Depreciation = original cost- scrap value Life of asset in hours Rs 10000- Rs 1000 = 10,000 hours Re .90 If the machine runs for 600 hours the amount of depreciation will be 540,( Re 0.90*600)
LECTURE 6
33

Advantages: This method has the advantage of correlating the charge for depreciation to the actual working time. Disadvantages: This method can only be used in case of assets whose life can be measured in terms of working time.

LECTURE 6

34

Group Depreciation Method or Block Depreciation method

Under this method all assets, generally having similar average life expectancy are grouped together as a single block. Depreciation is charged for the group in total and not item by item.

LECTURE 6

35

Depreciation or Sinking Fund Method.

According to this method, the amount charged by way of depreciation is invested in certain securities carrying a particular rate of interest. The amount received as interest is also invested along with the annual amount charged by way of depreciation. At the end of the life of the asset, securities are sold away and money realized is used to purchase of a new asset.
LECTURE 6
36

Selection of a suitable depreciation method

AS 6 does not specifies the method of allocation used by the management. Ideally method chosen should go according to the concept of periodic matching of cost and revenue. Practically the factors like simplicity, savings in record keeping costs, tax laws and legal requirement influence the choice of method. Companies Act, 1956 permits to choose between SLM and WDV method.
LECTURE 6
37

Change in the method of depreciation

Two different situations: 1. Change in the method of depreciation may be desired from the current year on wards(prospective change). 2. Change in the method of depreciation may be desired from a back date (retrospective Change).

LECTURE 6

38

Accounting for disposal of fixed assets

When assets becomes useless, they are scrapped(discarded), sold or exchanged for new assets. On disposal, the cost as well as accumulated depreciation is removed from the books. Disposal value is very rarely equal to its book value , so gain or loss on disposal needs to be recognized.
LECTURE 6
39